EU reform is good for our economy

The recent disagreement between the Government and the EU Commission concerning fiscal policy has caused some minor excitement in Dublin and Brussels. Fiscal authorities in the rest of the EU have also found the debate interesting. This wider interest does not arise from any particular concern about the Irish economy, but rather from the fact that the Irish example raises wider issues concerning fiscal policy co-ordination within the EU. Though the Maastricht Treaty and the Stability and Growth Pacts provided a framework for dealing with excessive deficits, the mechanisms of economic policy co-ordination within the EU are otherwise rather underdeveloped. While there are sanctions for countries running excessive deficits, the EU Commission is reduced to using "peer pressure" in cases such as that of Ireland. The co-ordination mechanisms were certainly not designed to deal with the case where a member-state runs a large surplus.

The weakness of the fiscal policy co-ordination mechanisms in the EU will be unaffected by the implementation of the Nice Treaty, which deals with other governance issues within the EU. Prior to Economic and Monetary Union (EMU), if the Italian government, for example, pursued an over-expansionary budgetary policy, the Bank of Italy had to raise interest rates if it wanted to keep inflation under control.

Such a rise in Italian interest rates had no adverse impact on Ireland or on the citizens of other EU countries. As a result, the rest of the EU did not have to pay the costs of unwise fiscal policy in Italy and there was no reason to seek to restrict the Italian government's (or any other member government's) freedom of action.

However, the experience of German unification in the early 1990s was a taste of the new world of EMU.

The German government partly financed unification through a big increase in government borrowing. The consequence of this fiscal expansion was that the Bundesbank had to raise interest rates by a substantial amount.

Because we were then members of the EMS, this had knock-on effects on Irish interest rates. Because of the dominant role of the Bundesbank in setting interest rates within the EMS, this ill-considered fiscal policy in Germany raised interest rates for all EMS members. In turn, this rise in interest rates halted the rapid growth in the Irish economy. Without this shock, the boom that Ireland experienced in the second half of the 1990s would probably have occurred five years earlier. The advent of EMU has significantly changed the economic environment. The example of German unification highlights the potential advantages to be gained from increased fiscal policy co-ordination within EMU - particularly advantages for Ireland and other small EU members. While independent fiscal policy action by individual member-states within the euro zone now has the potential to damage neighbouring economies, this is not obviously true in the specific case of Irish fiscal policy today. The general weakness of the world economy means that domestic demand within the euro zone is not putting upward serious pressure on the price level.

Instead, economic activity appears to be weakening and the European Central Bank (ECB) is more likely to cut interest rates in the future than to raise them. Thus the Commission's concerns about Ireland, while understandable, are probably somewhat exaggerated.

The irony of the dispute on whether Irish fiscal policy is appropriate is that the Commission is probably wrong in believing that it will adversely affect citizens in other EU states. However, from a purely Irish point of view, the expansionary nature of policy heightens the risks to the domestic economy from any major slowdown in the world economy.

As I have indicated in the past, the stimulus given to wage and house price inflation by the expansionary Budget poses dangers for the Irish economy. However, if the world economy achieves a gradual slowdown, rather than a recession, these fears will hopefully prove unfounded. It is only in the case where the domestic economy suffers a serious slowdown that the costs of that slowdown could be aggravated by current policy.

There is a fear in Ireland, and elsewhere, that fiscal policy co-ordination could involve pressure for harmonisation of tax rates within the EU. This is to misunderstand the reasons why co-ordination is desirable. If policy co-ordination should require a government to reduce (or increase) its borrowing, the wider interests of the EU can be met through either increasing taxation or reducing expenditure. It would be unnecessary and undesirable for the EU to specify the precise mix of policies to be pursued.

In the medium term, the favourable demographic situation of the Irish economy calls for a rather different policy than that required in less favoured countries, such as Germany and Italy. It will be appropriate for Ireland to reduce the current Government surplus to around 1 or 2 per cent of GDP through some combination of increased public services and reduced taxation. The only real concern is about the timing of such a reduction.

In the long term, whether or not the Commission is right, it is in Ireland's interests that fiscal policy co-ordination will develop to protect the economy from inappropriate action by other member-states. This co-ordination need not be unduly onerous. More often than not, countries will pursue fiscal policies that impinge little on the interests of their neighbours. Instead, it will be more effective if reserved for cases where there is a clear-cut benefit to the wider euro area from a Commission initiative.

John FitzGerald is research professor at the Economic and Social Research Institute.